The currency board arrangement was introduced in
Bulgaria on 1 July 1997. At the time it was indispensable.
At first the Bulgarian currency – the Lev – was pegged to the German Mark at a
1:1 exchange rate, and later repegged to the Euro at the same rate as the DM.

The current purchasing powers of the Mark/Euro and the
Bulgarian Lev are no longer the same as 11 years ago. A precariously large gap has accrued in the inflations of the Euro
zone and Bulgaria. Since mid-1997 to the end of 2007 the Euro zone has
accumulative inflation of about 20% while it has been almost 100% for Bulgaria.
By now the gap between their inflation and ours amounts to over 80 percent.

One
lev in Bulgaria will buy you now half the products you would have bought in
July 1997. To produce one Euro worth of product for export today takes twice
the amount in Levs than it did eleven years ago.

Producers
of the export goods find it hard to bear the consequences of this policy. This
though is not true of the Euro for inflation in the Euro zone is 4 to 5 times
lower than in Bulgaria. This appreciates the Lev in a pegged exchange rate
regime and contributes to the decrease of the already low export
competitiveness of domestic goods[1].The overvaluation of the Bulgarian Lev was noted in the latest
European Commission convergence report[2].

We are been told that one has to protect the stability
of the Lev. I am all for a stable Lev but this
cannot result merely from statements of goodwill. Long-lasting pegged exchange
rate with high inflation and barely any increase of productivity of labour can
hardly mean that the Lev is stable. Stability is but seeming. True stability of
the national currency may come around only through high growth and export
rates, high competitiveness, low inflation, rapid growth of labour productivity
and a reasonably balanced current account. In such circumstances the Lev would
be stable even without a pegged exchange rate.

For the past 11 years the stability of the Lev has
been artificially maintained by administrative means – through an exchange rate pegged to the Euro. But this could not
continue forever if it were not supported by the abovementioned economic fundamentals. These
prerequisites are missing in our case. We may go on for a while to maintain the
pegged exchange at the cost of substantial administrative effort but the
growing current account deficit would corner us even more[3].

And
then D-Day will dawn – the introduction
of the Euro. In the absence of the above fundamental economic prerequisites
even seeming stability of the Lev will be hard to maintain. That is when the
bubble will burst. Whether we like it or not – it will be taken care of by the
market.

Bulgaria
is expecting the introduction of the Euro – though not before another 5 or 6
years. The intentions of the authorities for this to happen around 2010 are not
realistic.

What
we might have to say would be how it would be introduced – gradually or
abruptly. Gradual introduction would be the preferred approach. To this end for
the past several years I have been recommending abandoning the fixed exchange rate of the Lev to the Euro and
transition to a managed floating rate, similarly to most CEE countries[4].
These countries have been developing better than us under floating exchange
regimes; they apply their own active monetary policies and have not been
exposed to threats of financial destabilisation.

Should
the government and the Board of Governors (BG) of the Bulgarian National Bank
(BNB) maintain the firmly fixed exchange rate until we join the Euro zone, they
ought to be aware that the longer this
lasts, the more difficult it would be to move from Lev to Euro. For even
further „inflation pressure“ would have accrued by then in the current exchange
rate of the Lev which would not have had a „breather“ through gradual
devaluation and would then need to deal with an even greater threshold from Lev
to Euro. This kind of policy effectively means postponing the difficult decisions for the future. However, this makes
them ever more difficult. The current authorities are acting so in the fear
of taking responsibility of performing this complex surgery.

If a
managed floating exchange rate were to be opted, then the BG of BNB should
identify the margins of that float of the Lev/Euro exchange rate. BNB should amend these margins each year or
more often depending on the inflation. The floating of the current exchange
rate must not exceed the margins. The Government and the BNB should severely
sanction any violators in order for businesses and people to trust them in
their determination and capacity to perform the delicate operation.

The amount of the amendments shall depend on the current annual inflation and the programme
(time-table) for the gradual „breather“ of accumulated inflation gap over the
previous years. By means of a precisely managed and non-jeopardising the
country's financial stability method, the gradual devaluation of the now
over-rated Lev would be achieved, as would be the latter's balanced market rate
to the Euro. It is recommended that the process goes hand in hand with an ever
more intensive increase in the labour productivity[5].
And so the economy would prepare for a less painful transition to the Euro in 5
or 6 years' time.

If, in accordance to the
Euro zone rules, the European Central
Bank demands of us two years of free „floating“ of the Lev prior to joining
which intends to identify the balanced exchange rate, Bulgaria would find it
easier to afford this after preparation as described and without risk of
destabilisation. There would still be disruptions but they would be bearable.
They would be inevitable as the inflation gap would not have been completely
let out yet. However, they would be more bearable as a considerable part of the
accrued inflation gap between Bulgaria and the Euro zone would have by then
been overcome.

If, as an exception, we were to join without a trial period and
straight away headed for a managed floating exchange rate to the Euro, there
would still be disruptions but within bearable limits due to our better
preparedness. The managed floating rate over a few years accompanied by a
gradual devaluation of the Lev is a preparation for a „softer touch-down“ for
the introduction of the Euro. It is a substitute for the demanded two-year free
„floating“. Free floating under current Bulgarian conditions would be very
risky undertaking.

If the current permanently pegged exchange rate policy
were to continue for another few years at the
expected high inflation rate, some
120-130 percentage points gap in the inflation of the Euro zone and Bulgaria
would accumulate just before the introduction of the Euro. This would be
inevitable with the revived inflation in the process of convergence of our
average level of prices with that of the EU[6],
the increase in the energy and food prices on the global markets and other
factors. The gradual convergence of prices, productivity of labour, income and
other indicators of the Member States is inevitable. Nobody could „forbid“ or
“bypass“ these fundamental processes. Equally nobody could „ban“ the higher
inflation in Bulgaria over the next years.

Convergence presumes a more rapid increase of the prices
in Bulgaria compared to the average inflation in the EU. This is „healthy integrational inflation“. The impact of the accrued
inflation towards the appreciation of the Lev at a permanently pegged exchange
rate might be partially neutralised possibly by rapidly increasing productivity
of labour. But that is not the case. The step by which we are catching up with
EU productivity of labour is three times smaller than that of some CEE
countries. The average annual rate of increase of the productivity of labour
over 2001-2007 in Bulgaria is merely 2.3%, or 3 to 4 times lower than the
average annual inflation. The substantial accrued inflation gap accompanied by
low and slowly increasing productivity of labour will result in a sever shock
at the time of introduction of the Euro, and will have grave economic and
social consequences for Bulgaria. For the exchange rate threshold we would need
to overcome from Lev to Euro would then be too high.

It would not be the Government, nor the BG of BNB to
dictate the exchange rate of the Lev to the Euro at that time but the market. The government may decide that salaries, pensions and other social
payments should be recalculated at exchange rate approximately 2:1 (two Levs
for one Euro as is our current exchange rate). But the market could not be tricked. Neither could it be dictated to!
It would probably decide otherwise: due to substantial appreciation of the
Bulgarian Lev, the exchange rate for recalculating the prices of the
commodities would no longer be 2:1, but 3:1 or 3,5:1 – i.e. not two but three
or even three and a half Lev to a Euro, to make up for at least part of the
accrued inflation gap over the years and the losses borne by the exporters. The
market will be the one deciding on the balanced exchange rate. This rate would
be by far closer to the economic truth than the current, administratively
defined pegged exchange rate.

Producers
and traders would compensate a large
part of the uncompensated increase in their costs in Leva over the past 11
years due to multiple increases of salaries; prices of land, energy and
fuels, row materials, components, assembling, freight, communication,
construction and other services, of rent and so on under a pegged exchange
rate. They would do whatever the competitive environment allows to stay on the
market. This would bring them a normal profitability in Euro. And nobody would
be able to reproach them for that. For it is not possible for the cost of each
and every production factor to have been increasing over a period of 11 years
while the price of the Lev in Euro remained the same, without having been
supported by substantial increase in the productivity of labour.

If no preparation was undertaken by means of transition to a managed floating exchange rate over the
years prior to the adoption of the Euro, this
would cause grave distress in income and prices and have dire consequences on
the economic activity and standard of living in Bulgaria.
Keeping up BNB's current cowardly policy is hardly
the policy Bulgaria needs. Each delay in the decision would increase the
economic and social price of the transition from Lev to Euro. For our economy
would not be prepared for an abrupt transition. And with time this transition
would inevitably get more abrupt and painful.

It
is not too late yet to adopt a managed floating rate. This way the economy
would prepare for the introduction of the Euro and avoid great concussions. For
the overvalued now Lev will inevitably
devaluate. And that will be painful. The question is whether that should happen
gradually over several years prior to the adoption of the Euro (and therefore a
little less painfully), or abruptly in a single go (and more painfully) – at
the time of the introduction.

What are the positive effects of the managed floating
exchange rate as preparation towards the adoption of the Euro?

First. Export driven
producers will be getting a larger amount equivalent in Leva. They would then
be able to afford larger investment to expand and modernise production
facilities, to increase the wages of their employees and achieve greater
profitability. Eventually the measured devaluation of the Lev would create a
more favourable economic climate for the increase of output and export, both of
which our economy is desperately in need of. For currently we are exporting per
capita 5 times less than Slovenia and about 4 times less than the Czech
Republic or Hungary;

Second. The devaluation of
the Lev will make import more expensive. The importers would be more vigilant
with what and how much to import and the latter to be reduced to reasonable
volumes;

Third. Expensive import
would allow for the return of local small and medium size producers who had
been pushed out of the market, with every positive economic and social effect
as a consequence;

Fourth. The exorbitantly
large deficit of the current account will start dropping;

Fifth. The economy will be
better prepared for the transition to the Euro and be spared the painful
economic and social concussions.

What would the negative effects be?

First. The government does
not enjoy the trust of the people and the business sector. It would take time
to convince them that it does indeed want and is capable of administering this
delicate operation in the interest of society rather than vested corporate
interests. As a result at first the exchange rate would not float but would
have almost a fixed upper limit within the floating margins while expecting new
devaluation. There would be restraint from investment and other economic
decisions over the first few months in expectation of the government's next
moves. There would be a decrease of Leva deposits in favour of Euro deposits
(which has already begun), and other forms of speculative operations with
Bulgarian currency prior to the introduction of the shared currency. Insecurity
may continue over several months depending on the determination with which the
government would act and the rate at which it would ear the trust of the
people;

Second. Some imported
goods would become more expensive and so would the goods produced locally with
imported materials and/or components. Indeed, their price is increasing already
as producers not always calculate imported materials and components for their
final output at the official exchange rate (2:1) but at a rate at their discretion
– 3:1 or 3,5:1, depending on the behaviour of their competitors. This would
increase the level of the average annual inflation over the next years to about
8-10 per cent. At first the effect this would have on the public might be
negative for they would not know that by doing this part of the accrued
inflation is being „taken in“, instead of erupting at once to 60-80 percent and
above in a transition to the Euro without proper preparation;

Third. There would be
increased costs to the budget with the price difference of imported products,
row materials, intermediate goods, products and services for the public sector.
And besides, the Government will spend more in Leva for servicing external
public debt and other fresh foreign borrowing of both government and corporate
sectors.

Some
might say that given the balance (one man's gain is another man's loss) it
would be on the whole the same to Bulgaria. It is not certain that there would
be a balance at macro-level. Even if it were to be there, it is not at all the same, since the agents to gain and loss are not
one and the same. Exporters would gain and output and export will rapidly
grow. Importers would become more cautious and import will not grow at the
current rates. There would be greater caution in providing imported goods for
the public sector. In the long run, production and export would grow, there
will be an increase in productivity and competitiveness and the current account
deficit would drop. On the whole Bulgaria would gain for it will live and work
in a closer to reality world instead of the distorted looking-glass of a world
at the current administrative exchange rate.

The
inconveniences described above are nothing compared to the concussions we will
be facing if we were to introduce the Euro without prior preparation and at the
current levels of accrued inflation gaps.

Discussions over the currency board arrangement and
the adoption of the Euro have been going on for a while in Bulgaria. Some economists are in favour of the gradual introduction with a
managed floating exchange rate in the meantime. Other economists and the
authorities lead by the BNB are committed to the permanently fixed exchange
rate and the direct transition, to the Euro even without the two years of trial
period. Third are for instantaneous, unilateral Eurosation. The latest option
is out of question for its obvious inappropriateness. It is good that the
ultimate decision will be made by the European Central Bank.

As
for the Bulgarian authorities, it is
time for them to take accountable action. The time for idleness is over! Those
who are stubbornly sticking to the pegged exchange rate by delaying the
difficult decision and shifting the responsibility for the complex operationover to a different time and different
people have to take full responsibility
for the consequences of their policy.

Published as an abridged version inCentral Banking, Quarterly Journal,Volume XIX, Number 1, August 2008

[1] The long lasting pegging
of the exchange rate of the Lev is one of the reasons, albeit not the most
important, for the small export and low competitiveness of our goods, and the
increasing current account deficit. According to the World Economic Forum,
Bulgaria ranks 79th in macroeconomic competitiveness, and 83rd
in microeconomic competitiveness. It is no coincidence that of all countries in
a currency board arrangement or with fixed exchange rates there are permanently
high and growing deficits on the current accounts. Based on Eurostat data, the
deficit of Bulgaria's current account for 2007 was 21,7% to GDP, while in
Bosnia and Herzegovina it was 19,8%, in Estonia 17,3%, in Lithuania - 13,7%. In
Latvia where there is no currency board but the exchange rate is permanently
pegged, the deficit was 22,9%

[2]“Bulgaria does not fulfill the exchange rate
criterion”.„The
Commission considers that Bulgaria does not fulfill the conditions for the
adoption of the euro”, European Commission, Convergence Report 2008, pp. 7 and
8.

[3] The deficit in the current
account was 5,6% of GDP in 2000, 9,3% in 2003, 14,8% in 2006, 20,7% in 2007 and
expected 25-26% in 2008. According to data from the BulgarianCentralStatisticalOffice the current account deficit for the
first 4 months of 2008 amounts to 2,43 bln Euro or
14,4% more than the same period last year.

[5] Bulgaria currently holds
last position among the EU member-states. According to Eurostat GDP per capita
for 2007 was 38,1% of EU-27 and labour productivity was 35,7%

[6] Based on Eurostat data, in
2006 the level of prices in Bulgaria was 44,8% of the average for the EU – 27,
with 75,3% in Slovenia, 66,5% in Estonia, 61,5% in the Czech Republic, 60% in
Hungary,57% in Romania, 69,9% in
Croatia. The data for 2007 has not
yet been published onthewebsiteoftheEU. The average annual HICPs
inflation in Bulgaria for 2000-2007 was 6,7%, with a
tendency for increase in rate: 6,1 in 2004, 6,0% in 2005, 7,4% in 2006, 8,4% in
2007 and expected at least 8 to 10% in 2008. Some Bulgarian economists expect
12-14 %=